Tuesday, February 10, 2009

One of the key elements of the Financial Stability Plan is to build "Financial Stability Trust" by conducting "A Comprehensive Stress Test for Major Banks" and providing investors and the public "Increased Balance Sheet Transparency and Disclosure".

Although lacking in details, this is a very good idea. A few suggestions:

Provide a timeline for conducting the stress tests of all institutions with more than $100 billion in assets (like 30 days).

Disclose the results with multiple scenarios on the Financial Stability website by bank (yes, name each bank and the future projected losses under each scenario).

A template for this disclosure could be the JPM presentation when they acquired WaMu.

Here is the table JPM provided:

Click on chart for larger image in new window.

JPM presented the WaMu losses from three scenarios: a base case (with national prices falling 25% peak to trough), a deeper recession (28% decline), and a severe recession (37% decline).

Although unemployment will probably exceed the JPM severe recession scenario of 8% - the point is investors now know that! We can see that in the severe recession, JPM expected national house prices to decline 37% and 54% in California. This would lead to an estimate $54 billion in additional losses.

Note: the toxic assets are frequently described as difficult to value, but the real problem is forecasting future defaults. This is why providing different scenarios for the stress test makes sense. No one has a crystal ball. For mortgage related assets, defaults correlate well with house price declines - so the JPM method is very useful. For other assets (like automobiles), unemployment is a better measure.

A table like this would allow investors and the public to understand which institutions are insolvent under different scenarios, and then provide a guide for the Capital Assistance Program (aka more capital injections). If a bank is massively insolvent, then the next step would be preprivatization. At least we would all know.

If JPM could put this data together in fairly short order, the other institutions - under the supervision of the government - could provide this data within 30 days. One of the key roles for the government would be to make sure the analysis is consistent between institutions: same scenarios, same defaults per house price declines, same results for similar securities.